Foreign currency translation

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Firms headquartered in a particular country often have substantial operations outside of that country. For example, in Note 1, ‘‘Basis of Presentation and Our Divisions’’ (Appendix A), PepsiCo indicates that it generates approximately 49% of its net revenues internationally (defined as outside the United States).For some firms (such as Coca-Cola), international sales dominate even though the firm is headquartered in the United States. U.S. parent companies must translate the financial statements of foreign branches and subsidiaries into U.S. dollars before preparing consolidated financial statements for shareholders and creditors. This section describes and illustrates the translation methodology and discusses the implications of the methodology for interpreting financial statement disclosures.

The following general issues arise in translating the financial statements of a foreign
branch or subsidiary:

•  Should the firm translate individual financial statement items using the exchange rate at the time of the transaction (referred to as the historical exchange rate) or the exchange rate during or at the end of the current period (referred to as the current exchange rate)? Financial statement items that firms translate using the historical exchange rates appear in the financial statements at the same U.S. dollar equivalent amount each period regardless of changes in the exchange rate. For example, land acquired in France for E10,000 when the exchange rate was $1.05 per euro appears on the balance sheet at $10,500 each period. Financial statement items that firms translate using the current exchange rate appear in the financial statements at a different U.S. dollar amount each period when exchange rates change. Thus, a change in the exchange rate to $1.40 per euro results in reporting the land at $14,000 in the balance sheet. Financial statement items for  which firms use the current exchange rate give rise to a foreign exchange adjustment each period
•  Should the firm recognize the foreign exchange adjustment as a gain or loss in measuring net income each period as it arises, or should the firm defer its recognition until a future period? The foreign exchange adjustment represents an unrealized gain or loss, much the same as changes in the market value of derivatives, marketable securities, inventories, and other assets

Functional Currency Concept
Central to the translation of foreign currency items under U.S. GAAP is the functional currency concept.Determination of the functional currency drives the accounting for translating the financial statements of foreign entities of U.S. firms into U.S. dollars. Foreign entities (whether branches or subsidiaries) are of two general types:

• A self-contained and integrated unit in a particular foreign country. The functional currency for these operations is the currency of that foreign country. The rationale is that management of the foreign unit likely makes operating, investing, and financing decisions based primarily on economic conditions in that foreign country, with secondary concern for economic conditions, exchange rates, and similar factors in other countries
•  A direct and integral component or extension of the parent company’s operations. The functional currency for these operations is the U.S. dollar. The rationale is that management of the foreign unit likely makes decisions from the perspective of a U.S. manager concerned with the impact of decisions on U.S. dollar amounts even though day-to-day transactions of the entity are usually conducted in the foreign currency

U.S. GAAP identifies characteristics for determining whether the currency of the foreign unit or the U.S. dollar is the functional currency. Exhibit 8.21 summarizes these characteristics. The operating characteristics of a particular foreign operation may provide mixed signals regarding which currency is the functional currency. Managers must exercise judgment in determining which functional currency best captures the economic effects of a foreign entity’s operations and financial position. As a later section discusses, managers may structure certain financing or other transactions to influence the identification of the functional currency. Once a firm determines the functional currency of a foreign entity, it must use that currency consistently over time unless changes in economic circumstances clearly indicate that a change in the functional currency be made.

There is one exception to the guidelines in Exhibit 8.21. If the foreign entity operates in a highly inflationary country, U.S. GAAP considers its currency too unstable to serve as the functional currency, and the firm must use the U.S. dollar instead. A highly inflationary country is one that has experienced cumulative inflation of at least 100% over a three-year period. Some developing nations fall within this exception and pose particular problems for U.S. parent companies. In its 2012 10-K, PepsiCo discloses that, although it generally designates the functional currency to be the currency of its foreign subsidiary, it designates the U.S. dollar as its functional currency for Venezuela due to its highly inflationary environment.

Translation Methodology Foreign Currency Is Functional Currency
When the functional currency is the currency of the foreign unit, U.S. GAAP requires firms to use the all-current translation method. The rationale for this method is that the firm’s investment in the foreign unit is for the long term; therefore, short-term changes

in exchange rates should not affect periodic net income. Under the all-current translation method,:

•  translate revenues and expenses at the average exchange rate during the period.
•  translate balance sheet items at the end-of-the-period exchange rate.
•  include the resulting ‘‘translation adjustment’’ (the amount needed to balance the balance sheet) as a component of other comprehensive income rather than net income
•  recognize the cumulative amount in the translation adjustment account in net income when measuring any gain or loss in the case of a sale or disposal of a foreign unit.

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